What is the “price level”?
The price level is a measure of the average price of goods and services in an economy at a point in time (Mankiw, 2024).
Index Number
There are thousands of prices, because of this, we don’t track each one separately. Instead, we combine them into an index number.
Common measures of the price level:
- CPI (Consumer Price Index): Average price of a “basket” of goods/services bought by a typical household.
- GDP Deflator: Average price of all final goods and services produced in the economy.
General Index Formula
All price levels are index numbers built around a base year.
- Base year index is always set to 100.
- If index = 120 → average prices are 20% higher than in the base year.
- If index = 80 → average prices are 20% lower than in the base year.
Example with a CPI-style basket
Suppose the “basket” is:
- 10 loaves of bread
- 5 bus rides
Base year prices
- Bread: $2 → cost = 10 × 2 = $20
- Bus: $3 → cost = 5 × 3 = $15
- Total basket (base year) = $35
Set base year index = 100.
Current year prices
- Bread: $2.50 → 10 × 2.50 = $25
- Bus: $3.50 → 5 × 3.50 = $17.50
- Total basket (current year) = $42.50
Now compute the price level index:
Price Level = (42.50 / 35) X 100 ≈ 121.4
Interpretation
- Price level ≈ 121 → prices are about 21% higher than in the base year.
Mankiw, N. G. (2024). Principles of Economics. Cengage Learning.
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